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Sec. 199 Final Regs. Affect Online Software and Advertising

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Tax Section

Editor: Annette B. Smith, CPA

Sec. 199 generally provides a deduction for
qualifying domestic production activities equal to 9% (3% for tax
years beginning in 2005 or 2006 and 6% for tax years beginning
2007–2009) of the lesser of the taxpayer’s (1) qualified
production activities income for the tax year or (2) taxable
income, determined without regard to Sec. 199.

On March 19, 2007, Treasury issued final
regulations under Sec. 199 (TD 9317) regarding online software and
the treatment of advertising income. The final regulations, which
differ slightly from the temporary and proposed regulations under
Sec. 199 issued 10 months earlier, generally are effective for tax
years beginning after March 19, 2007, but taxpayers may elect to
apply them retroactively to tax years beginning after 2004 (Sec.
199’s effective date) and before March 20, 2007.

The final regulations affect taxpayers
that produce computer software and provide access to it for a
customer’s direct use while connected to the Internet or any other
public or private communications network.

Online Software
Safe-Harbor Exceptions

Shortly
after Sec. 199’s enactment, the IRS and Treasury issued Notice
2005-14 to provide taxpayers with interim guidance in computing
the new deduction. (For a discussion, see Gibbs and Rathnau, Tax
Clinic, “Notice 2005-14 Offers Sec. 199 Guidance,”
TTA, June 2005, p. 339.) That guidance set forth the
general position that the use of computer software online by
customers is a service, and not a lease, rental, license, sale,
exchange or other disposition of the software. Accordingly, gross
receipts derived from such customers do not constitute domestic
production gross receipts (DPGR), because they are not
attributable to a qualifying disposition of the software.

In subsequent guidance (i.e., the
temporary regulations and, most recently, the final regulations)
regarding the treatment of computer software under Sec. 199,
Treasury and the IRS have continued to maintain the position that
the use of computer software online by customers is a service.
However, such guidance also has included two safe-harbor
exceptions that, if met, treat gross receipts derived from the use
of computer software online by customers as being derived from a
qualifying disposition of the software (and, thus, treat such
receipts as DPGR).

Safe harbor #1: Under the first safe-harbor
exception, Regs. Sec. 1.199-3(i)(6)(iii)(A), gross receipts
derived from providing computer software for customer use online
will be treated as DPGR if (1) the taxpayer sells the software
both online and affixed to a tangible medium (e.g., a CD) or via
an Internet download, (2) the software has only minor or
immaterial differences from the online software and (3) the
software has been manufactured, produced, grown or extracted by
the taxpayer in whole or in significant part in the U.S.

Safe harbor #2: Under the second safe-harbor
exception, Regs. Sec. 1.199-3(i)(6)(iii)(B), gross receipts
derived from providing computer software that has been
manufactured, produced, grown or extracted by the taxpayer in
whole or in significant part in the U.S. for customer use online
will be treated as DPGR if “another person” sells “substantially
identical” software to its customers affixed to a tangible medium
or via an Internet download. Regs. Sec. 1.199-3(i)(6)(iv)(A)
defines substantially identical software as software that (1) from
a customer’s perspective, has the same functional result as the
online software and (2) has a significant overlap of features or
purposes with the online software.

The final regulations do not define
“significant” overlap of features; unfortunately, the two examples
in the final regulations do not offer substantive guidance.

Comments

While the two
safe-harbor exceptions are largely the same in the final
regulations as in the temporary ones, the final regulations made
certain noteworthy changes. First, in response to comments, Regs.
Sec. 1.199-3(i)(6)(iii) clarifies that both exceptions extend to
computer software for which access is provided over any public or
private communications network, not just the Internet. Second,
Regs. Sec. 1.199-3(i)(6)(iii)(B) contains a potentially
significant word change for the second safe-harbor exception.
Under the final regulations, the taxpayer’s software comparison is
made with respect to “another person.” Under the temporary
regulations, the comparison was made with respect to “an unrelated
person.” Treasury officials have stated informally that the
language was changed to ensure that the second safe-harbor
exception applies when a taxpayer provides online software through
one entity and a related party to the taxpayer provides the same
software to customers affixed to a tangible medium or by an
Internet download.

Treasury and
the Service specifically rejected comments to expand the
safe-harbor exceptions to cover all use of computer software
online. Taxpayers noted that the computer software industry is
continually evolving; in the future, more software may be
available only online, thus limiting the potential applicability
of the two safe-harbor exceptions (i.e., over time, fewer
taxpayers will be able to meet either safe harbor). Treasury and
the IRS clearly recognized this point, but felt constrained by the
Sec. 199 statutory language requiring a lease, rental, license,
sale, exchange or other disposition of the computer software. In
their view, the two safe-harbor exceptions were narrowly tailored
to satisfy that language. Accordingly, Treasury and the Service
thought it inappropriate to expand the exceptions further as part
of the final regulations; see the preamble to TD 9317.

Online Software Advertising

Prior to issuance of the final
regulations, advertising income derived from (1) advertisements
placed in newspapers, magazines, telephone directories,
periodicals and other similar printed publications (collectively,
“newspapers”) and (2) advertisements and products placed or
integrated into a qualified film qualified as DPGR if the gross
receipts from the disposition of the underlying qualifying
property (i.e., newspaper or qualified film) were (or would be)
DPGR.

The final regulations
extend the favorable advertising rules to certain computer
software. Specifically, DPGR now includes advertising income
derived from advertisements and products placed or integrated into
computer software that is either affixed to a tangible medium or
provided through an Internet download; see Regs. Sec.
1.199-3(i)(5)(ii)(B).

Significantly, the favorable advertising
rule does not extend to advertisements and products placed or
integrated into online software; see Regs. Sec.
1.199-3(i)(6)(iv)(F). Commentators had requested such an
extension, but it was rejected. As noted above, Treasury and the
IRS felt constrained by the Sec. 199 statutory language and the
need for a qualifying disposition of computer software.

Conclusion

While the final
regulations made only slight changes to the online software rules,
many taxpayers nonetheless will be affected by them. For example,
taxpayers that produce computer software and provide access to it
for a customer’s direct use while connected to any public or
private communications network (not just the Internet) may qualify
gross receipts derived from these activities as DPGR. Moreover,
taxpayers that derive gross receipts from advertising or product
placements integrated in the software may qualify such receipts as
DPGR. Thus, the changes made in the final regulations provide
additional taxpayers with the opportunity to take advantage of the
Sec. 199 deduction.

Sec. 199 is
not a method of accounting but, rather, a permanent deduction.
Because of the final regulations’ retroactive applicability,
affected taxpayers can amend previously filed tax returns to avail
themselves of the favorable rules (e.g., the advertising rule
applicable to certain computer software) contained therein.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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